Catch the International Flight

First, the good news. The stock market crash of 2008 lasted through March 9, 2009, but things improved rapidly after that. From March through July of last year, Standard & Poor’s 500 stock index gained 35.62%, enjoying its best five-month run since 1938. For the entire year, the average U.S. stock fund returned about 33%, and virtually every category of mutual fund tracked by Morningstar wound up with positive results.

Now, the not-so-good news: Even the strong rebound of 2009 couldn’t make up for 2008’s crisis-fueled losses–and the rest of the decade’s abysmal performance. The 2000s, in fact, were the worst decade in almost 200 years of recorded stock market history. The S&P 500 lost an inflation-adjusted average of 3.3% each year between the end of 1999 and November 2009. For the entire decade, the average U.S. stock fund returned about 1.8% a year. You would’ve done better (and spared yourself a lot of heartburn) by simply rolling over bank CDs for 10 years.

For investors who applied the old textbook lessons of diversification (that is, managing risk by filling your portfolio with a variety of investment vehicles and holdings from different industries and global regions), the strategy paid off. Over the last 10 years, international stock funds have done much better than domestic funds, returning more than 3% per year. And, by comparison, diversified emerging markets funds were excellent performers, delivering annualized returns greater than 9% during the 2000s:

Let’s put that performance in perspective. If you had invested $10,000 in the average U.S. stock fund at the end of 1999 and kept your money there, your stake would have been worth about $13,250 by year-end 2009. By comparison, the same amount placed in the average diversified emerging markets fund would have grown to roughly $22,250. What’s contributing to this outsized growth? While industrialized nations struggled to escape the recession in 2009, emerging markets such as Brazil enjoyed economic growth of more than 4%; China’s economy grew by more than 9%.

Many in the U.S. are beginning to catch on to the international investment flight. In 2009, Americans invested a record $64 billion in foreign mutual funds, and more than half of that flowed into emerging markets equity funds; the rest went into foreign bond funds. Shaba Lightfoot was among those investors who looked beyond U.S. borders for investment opportunities last year. Lightfoot, a 27-year-old student affairs coordinator at the Association of American Veterinary Medical Colleges, a nonprofit in Washington, D.C., started investing in emerging markets when her employer switched retirement plan providers to AUL OneAmerica last winter.

After conferring with an AUL investment counselor, Lightfoot decided it was time to diversify her holdings. She placed about $5,000 in the American Funds Euro Pacific Growth Fund (A EPGX). The fund has nearly 29% of its assets in Asian, Latin American, and other emerging economies, with holdings in small firms as well as large corporations. The aim of the fund is to provide long-term growth. In 2009, the fund grew roughly 39%. “I had all my eggs in one basket,” she says. “I could have suffered a major loss if the performance was poor, but now I’m diversifying and developing a solid retirement plan.

Growth Prospects

Market experts are equally optimistic about emerging markets. “It’s not reasonable to expect another year like 2009,” says Bill Rocco, a senior analyst at Morningstar. “However, emerging markets funds are likely to reward long-term investors.” Simply put, developing economies are expected to grow more rapidly than the economies of the U.S., Western Europe, and Japan. There are literally billions of people in the emerging markets whose standard of living is improving. That mass movement toward the middle class is likely to lead to hefty profits–and higher stock prices–for the companies in those countries. The world’s largest emerging economies are Brazil, Russia, India, and China. Others include Argentina, Mexico, Poland, South Africa, South Korea, and Turkey. What all these countries have in common aside from transformational economies are large populations and abundant resources.

Lee Baker, president of Apex Financial Services in Tucker, Georgia, agrees that growth in the U.S. is likely to lag. “We’re industrialized and our economy is mature,” he says. “We’re not going to see huge investments in infrastructure, relative to our population.” Emerging markets, by contrast, are in the beginning stages of industrialization. “They’re building bridges and roads and airports. Those projects create good-paying jobs, so the emerging markets are starting to have the kind of middle class that we’ve had for years. Billions of people will be buying more goods and services.”

Modern technology makes a huge difference, notes Ivory Johnson, director of financial planning at Scarborough Capital Management Inc., an investment advisory firm in Annapolis, Maryland. “Now, people in the emerging markets have the same access to information we have in the U.S.,” he says. “That makes those countries even more competitive.”
Outsourced jobs from larger industrialized countries also influence growth in emerging regions. “Manufacturing jobs keep going over there because of the cost advantage,” Johnson says, “and they’re not coming back.” He notes that the U.S. dollar may continue to weaken as a result of the increasing national debt, and a weaker dollar will probably add to the returns of foreign investments, including those from emerging markets.

There are myriad reasons why investors look to emerging markets. Dominique Moore, 42, an attorney in Baltimore, became convinced of the viable investment prospects abroad after seeing a few of these vibrant markets up close. “I lived in South Africa for four years, and I traveled throughout the continent. I got to see how trade works, with raw materials going out and finished goods coming in,” says Moore. “Now that I’m back in the U.S., I notice that most of the things we buy come from other countries. I think the emerging markets will probably continue to have high growth, compared with developed economies.” Putting her investment dollars behind her beliefs, Moore has owned Driehaus Emerging Markets Growth Fund (DREGX) for several years. The widely diversified fund’s holdings go beyond the more familiar emerging countries to also include stocks from places such as South Africa, Egypt, Indonesia, and Israel. In 2009, the fund gained more than 70%.

Justin Garrett Moore (no relation to Dominique Moore), an urban designer with the New York City Department of City Planning, is investing in growing economies out of a sense of moral obligation to help less developed markets, in addition to the projected financial benefits. He has invested in a number of emerging overseas markets through his 457 retirement plan. The 30-year-old holds the TIAA-Cref International Equity (TRERX), the Aberdeen Global SRI Equity Fund, and New Alternatives (NALFX) fund, all of which have roughly 12% of their holdings in emerging markets. Although investing overseas was once seen as high risk, Moore recognizes the superior growth prospects. Besides, he says, “I’m young, so I can take on more risk.” Moore also devotes a small portion of his investment dollars to microfinance ventures in developing nations.

Multiple Choices
If emerging markets appeal to you, there are several types of funds in which you can invest:
Diversified emerging markets funds. As you’d expect, these funds buy companies based anywhere in the world, outside of the industrialized nations. Recently, the funds in this category invested largely (14.36% of assets) in Brazil, followed by China (13.55%), South Korea (9.34%), Taiwan (8.03%), and South Africa (6.21%). “For most investors, the best way to participate in emerging markets is through a diversified fund,” says Rocco. “Let the manager decide on the countries and stocks that seem most attractive.” Large mutual fund families often have researchers and analysts who focus on a specific emerging nation or region.

Latin American stock funds. These funds have been extraordinary performers. The average 10-year annualized return in this category is 15.23% through the end of January 2010. “They’re basically Brazil and Mexico funds,” says Rocco, “because most of the assets in these funds are invested in those two countries, especially in Brazil. They’ve profited recently from the strength in oil and metals companies based there.”

Pacific/Asia ex-Japan funds. Except for Japan, all Asian countries may be considered emerging markets; holdings in this category differ but they tend to focus on China, Hong Kong, India, and Korea. For the past 10 years, the average annual return for this category was 8.41% through January.

Rocco is generally not enthusiastic about regional or single-country emerging markets funds. “They may be more volatile than diversified funds,” he says. The Asian financial crisis of 1997—1998 punished regional stock funds there, while Latin American funds have posted losses in five of the past 12 years, including a 59% slide in 2008.

Do regional emerging markets funds ever make sense? “Perhaps,” says Rocco, “if you have a large portfolio that already includes domestic stock funds, an international fund for developed markets, and a diversified emerging markets fund. In that situation, you might invest a small portion of your portfolio in a region or country that you believe will do better than the rest of the world. But you should treat a regional or single-country emerging markets fund like a stock that might do very well or very poorly.”

Emerging markets bond funds. Government and corporations in emerging markets may borrow money via bond issues; several mutual funds hold these securities. These funds offer generous yields (the category average is now around 5%, compared with domestic bond funds, which average 4.42%) as well as the chance for capital appreciation.

Over the past 10 years, emerging markets bond funds have returned 11.07% a year, which was higher than the average for diversified emerging markets stock funds. They’ve been less risky than the stock funds, too: In 2008, when emerging markets stock funds lost nearly 55%, the bond funds lost only 17.64%.

Even though emerging markets bonds have been strong lately, Johnson is unmoved. “With any bonds you have exposure to interest rates. If rates rise from today’s low levels, your bonds will lose value. With emerging markets bonds, prices may fall rapidly if there’s any sign of political unrest.” Rocco agrees that emerging markets bond funds tend to be more volatile than other types of bond funds, but says they might be suitable for some portfolios. “Just as some investors might want to hold an emerging markets stock fund as part of their equity allocation, so an emerging markets bond fund might fit into a fixed-income allocation,” he says. “Along with the volatility, there is the chance for substantial returns.”

Playing the Percentages
Many observers like the growth prospects for emerging markets but caution against overloading there because of the risk of downward swings. Johnson says his clients typically invest 10% of their portfolios in emerging markets. “I like inexpensive, well-diversified funds,” he says. “If you buy one country or one region, you might be too dependent on one commodity or too exposed to a local economic problem.”

Apex’s Baker recently recommended to Marlene Blaise, 41, a cardiologist in Alpharetta, Georgia, that she invest 3% of her portfolio in Vanguard Emerging Markets Index Fund (VEIEX). The Vanguard fund’s low expense ratio is the key to its appeal: It charges 0.40% of assets per year, while the average diversified emerging markets fund charges 1.77% a year. “The cost advantage of this Vanguard index fund is so great,” says Baker, “that other funds will have a difficult time matching its performance over the long term. As for asset allocation, Baker says that Blaise’s 3% commitment is moderate for his clients. “Some conservative clients have no emerging markets at all, while others have as much as 5%. Down the road, I might suggest that Blaise increase her emerging markets allocation to 5%, perhaps by adding a country-specific fund focused in Brazil, India, or China.”

Blaise believes that venturing into an emerging markets fund will be worthwhile. “Emerging markets have tremendous growth potential,” she says, “probably more than developed markets have now. In addition, diversifying your investments makes sense.”

By diversifying into asset classes such as emerging markets, which don’t always move in sync with U.S. stocks, you may get valuable noncorrelation. In 2007, for example, the average U.S. stock fund returned less than 7% while diversified emerging markets funds returned nearly 37%, on average.

“When determining how much of your money to invest in an emerging markets fund,” says Rocco, “check to see how much of your portfolio is already invested there.” Suppose, for example, you want a 10% allocation to emerging markets. You own a foreign stock fund that invests mainly in developed markets; that fund makes up one-fifth of your portfolio. If that fund has 15% of its assets in emerging markets, you already have a 3% (15% of one-fifth) exposure to emerging markets through that fund. You could invest another 7% of your portfolio in an emerging markets fund to bring your allocation up to 10%. The experts who talked to black enterprise for this story recommend that no more than 10% of your portfolio be invested in emerging markets.

Patience is prudent. Emerging markets will probably deliver good returns over a 15- or 20-year time period because of underlying economic growth, but there may be sharp declines along the way as a result of economic crises, political instability, and other problems that developing nations can encounter. “You need a long time horizon,” Rocco says.

“I’m in for the long haul,” says Dominique Moore. “I reinvest all distributions back into the fund. I have no intention of selling. If the fund goes down, I plan to ride it out. I don’t watch over this fund too closely because checking too often doesn’t help my peace of mind.”

Slow and Steady
Rocco warns that investors should be cautious about investing in an asset class that has enjoyed as much recent success as emerging markets, because there’s a risk that you’re buying near a market top. He suggests investing gradually, using dollar-cost averaging, perhaps every month or quarter. That approach reduces the risk that you’ll invest a large sum just before prices plunge.

“There are some other ways to benefit from the expected growth of emerging markets,” says Johnson. “For example, China has more than 20% of the world’s population but has less than 15% of the world’s arable land and about 7% of its potable water supply. As emerging economies develop, the people in China and other nations will be eating more, and someone will have to feed them. That’s likely to increase demand for companies in businesses related to agriculture.”

Therefore, Johnson recommends that his clients own Van Eck Market Vectors Agribusiness ETF (MOO), an exchange-traded fund that holds stocks such as Monsanto and Deere, which provide farm-related products and services. Similarly, Johnson’s clients hold managed futures, which may deliver excellent returns if demand from emerging markets drives up commodity prices, including agricultural commodities. Rydex Managed Futures Strategy (RYHFX) is a mutual fund focusing on futures contracts. As billions of people in developing nations eat more food, drive more cars, and make more cell phone calls, you’ll want to hold some funds designed to capture the investment returns that are bound to emerge.

–Additional reporting by LaToya M. Smith

This article originally appeared in the April 2010 issue of Black Enterprise magazine.